The consequences of short squeezes

Short selling – betting on a stock to fall in price by borrowing shares to sell them, hoping to buy them back at a future date at a lower price – is risky because losses are unlimited (unlike going long, where losses are limited to your investment). Short selling involves other risks as well. Because short sellers need to borrow shares to sell, and shares are almost always borrowed for one day at a time, short sellers face the risk that borrowing fees will increase before a short position is closed. A third risk is that the price of the shorted asset will increase in the short run and the short seller will be forced to post more collateral. A fourth risk is that when the lender of shares to the short seller wants to sell the stock and thus demands the borrowed shares be returned, the short seller will be unable to locate an alternative source of shares (a short squeeze occurs). If that happens, the short seller will be forced to buy back the stock in order to return the shares borrowed.

Because short sellers exit their positions with buy orders, their exit can push prices higher, which leads to more covering of short positions, creating a vicious circle. The rapid rise in price can attract buyers looking to “jump on the bandwagon” to exploit the short squeeze. The combination of new buyers and panicked short sellers can lead to stunning and unprecedented increases in valuation to levels well above anything that could be justified by a stock’s fundamentals – such as occurred with GameStop. This opportunity, along with the excitement created on social media investment sites such as Robinhood and Reddit that short squeezes can generate, presents an attractive target to investors who seek out investments with “lottery-like” distributions.

Metrics have been developed to measure the risk of a short squeeze. For example, the short interest ratio, or “days to cover”, indicates in days how long it would take to cover or buy back all the shorted shares, calculated by dividing the number of shares sold short by the average daily trading volume. The greater the number of days, the greater the risk of a short squeeze. A second measure is “short interest as a percentage of float,” calculated as the number of short-sold shares in proportion to the total number of shares available for trading. Most stocks have a small amount of short interest, usually in the single digits. However, if the short percentage of the float reaches 10% or higher, it is a warning sign of the potential for a short squeeze.

The role of short sellers

Short sellers play a valuable role in keeping market prices efficient by preventing overpricing and the formation of price bubbles in financial markets. Market efficiency is important because an efficient market allocates capital efficiently. If short sellers were inhibited from expressing their views on valuations, securities prices could become overvalued and excess capital would be allocated to those firms.

The importance of the role played by short sellers has received increasing academic attention in recent years. Research into the information contained in short-selling activity include the 2016 study “The Shorting Premium and Asset Pricing Anomalies,” the 2017 study “Strategic Behavior by Equity Lenders,” the 2020 studies “Securities Lending and Trading by Active and Passive Funds” and “The Loan Fee Anomaly: A Short Seller’s Best Ideas,” and the 2021 study “Investors’ Quantitative Disclosure: Target Prices by Short Sellers.” It has consistently found that short sellers are informed investors who are skilled at processing information (though they tend to be too pessimistic). That is evidenced by the findings that stocks with high shorting fees earn abnormally low returns even after accounting for the shorting fees earned from securities lending. Thus, loan fees provide information in the cross-section of equity returns.

These findings are consistent with economic theory: Hard-to-borrow stocks will earn low returns because short-sale constraints prevent short sellers from trading. Thus, their prices reflect the opinions of optimistic investors only — leading to their being overpriced and underperforming in the future.

New research

Paul Schultz contributed to the short selling literature with his study “Short Squeezes and Their Consequences,” published in the February 2024 issue of the Journal of Financial and Quantitative Analysis. Schultz developed two metrics he used to predict the risk of a short squeeze. The first proxy, which corresponded to what he called an “all-lender squeeze,” indicated that a squeeze had occurred when the shares available to lend were less than the shares on loan the previous day: “The all lender squeeze proxy implies that there are not enough shares available for short sellers anywhere.” The second short squeeze proxy, which he called a “current-lender squeeze,” indicated that a squeeze occurred if the total number of shares available to lend and the number of shares on loan fell by the same amount on the same day. His sample relied on IHS Markit data and covered the period 2006-2019. Following is a summary of his key findings:

Equal declines in shares on loan and shares available to lend were short squeezes and not just coincidence — a decline in shares on loan was 15 times as likely to be matched by an equal decline in shares to loan on the same day as on the day before or after.
Equal declines in shares on loan and available shares were much more common when it was harder to locate an alternative source of shares.
A large portion of current-lender squeezes were also all-lender squeezes.
For most stocks, at most times, squeezes were rare — on just 0.183% (0.469%) of the days there was an all-lender (current-lender) squeeze, and just 0.102% of the days were classified as having both an all-lender squeeze and a current-lender squeeze (more than 100 times as many as would be expected if they were independent events).
For most stocks, the expected trading costs from short squeezes were trivial because the likelihood of a squeeze was very small. There was also little variation in the fees for easily borrowed stocks. The 25th percentile of fees was 37.5 basis points per year, and the median fee was also 37.5 basis points per year. The distribution of borrowing fees was right-skewed, with a mean of 2.673% and a 95th percentile of 11.0% — most stocks could be borrowed cheaply, but some were very expensive to borrow.
The single best predictor of short squeezes was utilization – the percentage of available shares that were on loan.
Short squeezes from loan recalls explained why the number of shares available to lend and the number of shares on loan fell by the same amount on the same day.
Squeezes were more common for small firms than large firms and much more common for stocks that were hard to borrow than stocks that were easily borrowed — when utilization was 25% or less, as it was for about three out of four stocks, an all-lender squeeze occurred about once every 40 years. When utilization was 90% or more, an all-lender short squeeze occurred about once every 11 days.
When borrowing fees were less than 50 basis points per year, a current-lender squeeze occurred about once every 10 years. When fees were greater than 10%, a current-lender squeeze occurred about once every 25 days.
Short squeezes significantly reduced expected returns to short selling by forcing short sellers to bear trading costs from closing and reestablishing positions, and by forcing them to close positions before stocks declined.
For hard-to-borrow stocks with borrowing fees of 25% or more, the expected trading costs from short squeezes were 29 to 37 basis points per month.
For stocks with utilization rates of 90% or more, the expected trading costs from short squeezes ranged from 56 to 73 basis points over the next month and from 1.04% to 1.34% over the next quarter.
The inability to reestablish a short position after a squeeze was also costly. When investors shorted stocks with utilizations of 90% or more, they could expect to miss -30.9 basis points of excess returns over the next month because short squeezes occurred and they could not reestablish positions quickly. Over the next quarter, short sellers of those stocks were, on average, on the sidelines during excess returns of -0.937% following squeezes.
Short squeezes significantly reduced the returns to short selling. For stocks with utilization above 90%, the mean excess return over the next month was -1.293%. The expected costs from squeezes ranged from 0.873% to 1.039% – more than two-thirds of the excess returns to shorting those stocks was lost to the costs (including bid-offer spreads, which widen during squeezes) of short squeezes.
Low-fee, low-utilization stocks earned statistically significant positive abnormal returns, while high-fee, high-utilization stocks earned significant negative abnormal returns. The portfolio of stocks with the lowest 10% of utilizations among stocks in the lowest half of fees earned an average abnormal return of 56 basis points per month. The portfolio composed of stocks with the highest 10% of fees and highest 10% of utilizations earned abnormal returns of -2.67% per month.

His findings led Schultz to conclude: “High fee stocks earn significant negative abnormal returns, which compensate short sellers for borrowing costs. In addition, holding fee constant, I find that high utilization stocks, which are most likely to experience short squeezes, earn significantly lower returns than low utilization stocks. This is consistent with the risk of short squeezes being incorporated into share prices.” He added: “Short sellers who are unlucky and are forced to close positions will lose far more to trading costs and foregone returns than the expected costs.”

Takeaways

A large body of evidence demonstrates that short sellers are informed investors who play a valuable role in keeping market prices efficient — short selling leads to faster price discovery. However, short selling entails significant risks — risks that have increased as markets have become more inelastic. In their 2022 study, “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis,” Xavier Gabaix and Ralph Koijen demonstrated that markets have become less liquid and thus more inelastic. They estimated that today $1 in cash flow results in an increase of $5 in valuation.

One explanation for the reduced liquidity is the increased market share of indexing and passive investing in general. Reduced liquidity increases the risks of shorting. The result has been that while the game of short selling isn’t over for hedge funds, the threat of retail investors banding together (as they did in 2021 with GameStop) has led to a significant decrease in their shorting activities in heavily shorted stocks. The limits to arbitrage have increased, allowing for more overpricing of “high sentiment” (typically glamour growth) stocks, making the market less efficient. Thus, one takeaway is that we are likely to see more persistent overpricing on the wrong side of anomalies — and ultimately crashes as the fundamentals are revealed.

Another takeaway is to avoid being a noise trader. Don’t get caught up in following the herd over the investment cliff. Stop paying attention to prognostications in the financial media or posts on social media. Most of all, have a well-developed, written investment plan. Develop the discipline to stick to it, rebalancing when needed and harvesting losses as opportunities present themselves.

Finally, be aware that fund families that invest systematically (such as AQR, Avantis, Bridgeway and Dimensional) have found ways to incorporate the research findings on the limits to arbitrage and the evolving changes we have discussed to improve returns over those of a pure index replication strategy. It seems likely this will become increasingly important, as the markets have become less liquid, increasing the limits to arbitrage and allowing for more overpricing. The evidence demonstrates that you should not own stocks with high borrowing fees. Forewarned is forearmed.

LARRY SWEDROE is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data and may become outdated or otherwise superseded without notice. Third-party information is deemed reliable, but its accuracy and completeness are not guaranteed. Mentions of specific securities are for informational purposes only and should not be construed as a recommendation. Investing involves risk. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this information. The opinions expressed here are their own and may not accurately reflect those of Buckingham Wealth Partners. LSR-24-631

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